What The Markets Are Telling Us About Interest Rates

What The Markets Are Telling Us About Interest Rates

 

It is no secret that the Fed is about to end purchases of U.S. treasury and mortgage securities later this year.  There is also talk of increasing the Fed Funds rate sometime next year.  What does this mean for fixed income investors, and how should their portfolios be structured for a rise in rates?  There are some things we can learn from the bond market to help us with this decision.

 The Bear Flattening Trade

Markets often anticipate future changes.  One indicator we follow for confirmation of our Fed thoughts is the spread between 5 year and 10 year treasuries.  The graph below shows changes in the Fed Funds rate compared to the spread between 5 year treasuries and 10 year treasuries for the period from January 2000 to the present.  The blue represents the Funds rate and the orange represents the yield spread between 5 and 10 year maturities.  Changes in this spread tend to precede changes in the Fed Funds rate.  When the bond market feels short term rates are going higher investors sell 5 yr bonds and buy 10 year bonds in anticipation of Fed rate hikes.  The lower the spread the flatter the yield curve is.  The spread is now at the lowest it has been since the Fed took the Funds rate down to zero.  This indicates a rate increase is likely.

 

Why Buy Longer Bonds If Rates Are Going Higher?

 

Investors may question the wisdom of buying long bonds if the Fed is going to raise rates.  Here are some of the reasons this makes sense:

1.      Short term rates have more potential bp’s to rise and will rise more quickly than long term rates.  These portfolios are duration weighted to temper the risk of long term bonds declining in value.

2.      Investors are still being paid to extend maturities and the higher rates on longer bonds help mitigate declines in value.

3.      Inflation is barely at the bottom of the Fed’s target range.  Any increase in short term rates will likely lead to inflation expectations being well contained.

4.      Increases in short term rates will provide a headwind for the economy. This will lead to subpar economic growth.

 

A Look at the Fed Funds Futures Market

The chart below shows what the futures market expects the Fed Funds rate to be for the next few years.  The expectation is that the Fed Funds rate will be about the same for the next 6 months and will then start to rise to 0.73% at the end of 2015.  According to the futures market it will continue to rise to 1.79% by the end of 2016.  Both of these indicators show the market is telling us an increase in the Fed Funds rate is coming.

 

 

Fed Funds and the Yield Curve

When the Fed talks about raising rates they are talking about the Fed Funds rate.  However, when investors think about rising rates they worry about a decline in value of their longer bonds.  Our research shows a strong correlation between the Effective Fed Funds Rate and the 10 year treasury yield.  The table below shows that the average spread between the Fed Funds rate and the 10 year for the period from 1/1/1962 to the present was 100 bp’s, and the maximum spread was 390 bp’s.  In fact, about a year ago we felt 3.0% yields on the 10 year were very attractive since the 10 year was yielding more than 300 bp’s over the Funds rate.

 

 

Municipal vs. Treasury Ratios

We have also studied the relationship between Munis and treasuries.  The table below shows the long term expected ratio for a 10 year Muni vs a 10 year treasury is about 80%.  These ratios vary widely depending upon market conditions.  However, we can use the expected ratios below to give us some idea of what to expect if the Fed normalizes rates beginning next year.

 

 

Higher Rates For Fed Funds

Using the historical relationship between the Expected Fed Funds rate and various points on the yield curve we can then do a shock analysis to determine what to expect if the Fed raises rates.  The table below shows  modeled yield curves for both Munis and UST  assuming an increase in the Funds rate to 1% and 2%.  It may surprise some investors to see that for a 1% Funds rate we should expect the 5 year to be about the same as it is now, and the 10 year actually looks cheap compared to an expected yield of roughly 2.0%.  We would argue that the market currently discounts a 1.0% Funds rate.  If the Funds rate goes to 2.0% we should expect a rise in the 5 year of about 100 bp’s and the 10 year about 60 bp’s.  Munis show similar results, except the 10 year Muni is fairly valued at a 2.0% Funds rate.

 

Conclusion

Fears of rising rates are greatly overblown.  The market has already discounted a 1% Funds rate.  Any rise in the Funds rate will likely be several months from now and will be limited in amount.  Under current circumstances it seems likely the Funds rate won’t be over 1% until the end of 2015, and might not reach 2% before the end of 2016.  These increases are data dependent and won’t occur unless the economy grows faster than we have seen so far.  In the past we have cautioned about placing too much faith in the rate  predictions of the Fed.  Fed members have been predicting higher growth rates for the economy for some time and have a history of being overly optimistic about their growth expectations. 

Since the economy still has too much debt and the demographic trends are still negative, we feel the risk to economic forecasts is to the downside.  We believe rates are likely to be low for a long period of time and rate increases in the Fed Funds rate will tend to be an additonal headwind for economic growth.  If we are correct, then the yield curve will continue to flatten.  An appropriate strategy for bond investors is a barbell strategy consisting of some bonds with very short maturities and some longer bonds.  We also are placing an emphasis on credit spreads as a way to increase returns.  These strategies have worked well for us year to date.